Sunday, May 1, 2016

Actions Coming from China, Berkshire Hathaway, and Caltech


I am always looking for help in investing clients and my family’s money each week. I review my exposures to breaking news and views. l have reviewed the actions of the latest week and there was a lot to learn.


One of my basic beliefs for the next fifty or so years is that what happens in China will have material impacts on global markets as well as individual lives in many locations. Whether these impacts will be positive or negative will probably be a function on how well we are prepared to understand the implications of the actions taken in the Middle Kingdom.

Market reports noted growing illiquidity in both the internal stock and commodity markets. The volume in the steel contracts is twice the combined volume of the two largest Chinese stock markets. This demonstrates that speculative interests can find outlets in local as well as global markets. I do not know how much of the steel action is short covering or anticipation of growing infrastructure spending which could well impact global commodity demand and therefore the craving for industrial stocks.

To get a handle as to how important the Chinese markets are to the global picture, one needs to understand that almost half of the derivatives traded in the world are traded in China. Because of the huge amount of leverage that can be involved in derivatives they can be a source of disruption that will affect both the banks and the stock markets in general. Thus my fellow domestic stock and equity fund holders need to keep an eye on the commodity and derivative markets in China. This is particularly true as government policy is favoring restructuring the Chinese economy and society into companies with fewer employees producing products and services in which demands exceeds supply. This is not an easy task even in a command economy.

Berkshire Hathaway's Annual Shareholders Meeting

Some may have come away from the 51st annual meeting with the belief that very little new information was released. However, there were a number of forward-looking comments that could be useful in thinking about future investing. Some of the nuggets are as follows:

1. Too much capital going into a sector or asset class can reduce its attractiveness. A UK manager, Marathon Asset Management, has developed a successful record using the swings in capital market flows.

2. Increasingly consumers are being attracted to "pull" over "push" marketing, particularly through the Internet. Consumers are actively pulled into the net as distinct from reacting defensively when pushed. This favors manufacturers/distributors over the retailers.

3. Eventually the real value of hydrocarbon production will be to supply chemical feedstocks. Remember Dustin Hoffman’s discovery of plastics in the film “The Graduate.”

4. There are areas that are unattractive for investment that include packaged goods, general leasing, and reinsurance.

5. Cash has imbedded an option cost inherent when it is not employed.

6. As a private company rather than a public company there are distinct operating advantages (such as freedom from quarterly earnings pressure) that Berkshire can offer to an entrepreneurial, publicly traded company.

Caltech Fund Raising

Those of us that have deep interest in both commercial and non-profit activities are well familiar with fund raising. Most of the time money is being raised to expand physical capacity. More people are to be hired to serve a greater market size.

As usual, the California Institute of Technology is unusual in its fund raising. Using its own words, “Transformative investigations underway at Caltech will come to life as institute scholars recount the powerful questions they are posing and the surprising answers that emerge.”

This weekend it is entering the public phase of a $ 2 Billion campaign after raising $1 Billion in its private phase. What is unusual is the new capital is not being raised to add students to its small base of undergraduates, graduates, and post doctoral students. The money, in effect, is being raised to expand its intellectual capacity to evolve groundbreaking research. New planets and black holes are to be found, new linkages from advanced developments of biology, chemistry, physics. What particularly interests me is developing an understanding how different elements in the brain lead to various micro and macro decisions; e.g., getting married.

The big investment lesson that I draw from the Caltech campaign unlike most capital raising, is its intent is to get better not bigger which is a tall order because on many scales it is already the best at what it does. For those of us in the investment business it is a call to get better at what we do rather than getting more money to manage.

Question of the week: What are your reactions to these lessons?
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Sunday, April 24, 2016

More Opportunities from Disruption + Confusion


One of the relatively consistent habits of people in the global financial community is an insatiable focus on the current price trends and almost no focus on factors that may reshape their workplace. I see this right now, but I should admit by nature I am a contrarian and that I often focus on what I see coming over the horizon.

Financial Services Employment

Knowing people within the financial community I am conscious of an increasing number of senior employed executives looking for new opportunities and those recently “at liberty.”

Over the years this has happened a few other times and in most cases my friends have found new and profitable activities. During these periods I have said that based on the available people, on paper, I could form one of the best financial groups in the business. (The reason for the “on paper” caveat is knowing the personalities, I am not sure all of these experienced people could work well together.)

I perceive we have entered another and perhaps much larger such period. Recently I have had conversations with presidents of large and small investment funds groups, senior traders, strategists of various types, etc. Part of this personnel reduction is due to present and projected profitability squeezes. Part may be due to low (relative to the past) prices for financial organizations. As an investor in financial services stocks I am used to seeing this kind of cyclical behavior. Too many people within the financial community believe that their own value is similar to whatever is the current growth stock leader.

The problem of risk management is tied to the growing illiquidity in the markets which is addressed by Jamie Dimon on pages 19 and 20 in the JP Morgan Chase annual report*. With his personal worry about abrupt rise in interest rates, it is likely that markets will become more illiquid and some traders and investors will be shouldering more risk.
*A personal holding. I will be happy to send those copyrighted pages to subscribers who contact me. 

Using the often used phrase “This time is different,” I think we may be entering a new phase. For many years we have been going through a concentration phase largely through mergers or acquisitions. This trend could well see a reversal in the next couple of years and the individual investor could be the loser.

Government Interference in Compensation

On both sides of the Atlantic as well in selected Asian countries governments are interfering in the compensation practices of large financial organizations. Officially the politicians drive is to reduce the risk taking that leads to government bailouts. (A far better way to do this is to prohibit such rescues by the politicians in governments and particularly in their central bank dependents in sponsoring bailouts.) The latest action by the US government is to require those in senior jobs or those in a position to assume risk to have the bulk of their income to come from deferred equity ownership that will vest in 4 to 7 years and be available for recapture for cause.

New Enhanced Trading Groups

I suspect the real motivation on the part of these bureaucrats is to address their concerns for wealth inequality both on the personal and corporate levels. The initial rules are built on a scale with the greater the assets owned the more draconian the implications. The focus is on principal trading. If these regulations are fully implemented it is where the job and profit opportunities will be created. Instead of the bulk of trading being conducted on exchanges and by the members of the concentrated players, it will shift to smaller asset owners who control large amounts of clients’ money; e.g., Hedge Funds or similar non-deposit taking groups. These groups will have no obligations to the marketplace and/or to provide service to individuals. In effect we will have reinforced the kind of private markets that currently run most of the commodity and real estate markets. The new enhanced trading groups will need research for both decision-making and institutional marketing. Some of these groups will gather money through accounts, others may use private vehicles that that have similar characteristics to mutual funds.

Historically any attempts to legislate risk has only shifted to other locations including beyond borders. Thus the aggregate total of risks assumed is unlikely to change. People’s business cards and the location of some of their computer servers accessing the Cloud will change. By the way, the biggest source of risk for most citizens is the induced risk that is inherent in current government practices; for instance deficits, unfunded liabilities, and unaccounted for contingent risks.

The Enthusiasm Watch

As repeatedly set forth, I am on the watch for growing enthusiasm for stock prices as a warning device of a major top. Here are three cautionary signs:

  • Only three of forty-four markets tracked by The Economist declined in the week ending April 20th.

  • Both in the US and Europe mutual fund investors are putting money into Fixed Income funds and out of Money Market funds showing a lack of Jamie Dimon’s concern about rising rates.

  • Barron’s Big Money Poll of global money managers has 35% bullish and only 16% bearish with 49% neutral. However 59% are bullish on commodities. (They must have high confidence in their individual selection skills for their outlook for corporate profits this year is under 5% and under 10% in 2017. This suggests reliance on concentrated, less diversified portfolios.)

Standard Approach to Look for New Winners

One of the lessons I learned from an old market pro was to search the new low list for future winners. This is why I insisted on showing the lagging funds much to the annoyance of fund managements when I was publishing Mutual Fund Performance. I still believe it is a good exercise in the search of future winners. This view was reinforced with the arrival of Dimensional Fund Advisors' Matrix Book.

Near the very end of this interesting compendium were two pages that looked at twenty years of relative performance of developed and emerging markets which I found to be instructive. Below is a table for the last six years of the best and worst performing countries in these two universes:


New Zealand  

My data analysis points out how rare there is a repeat with only USA having a next year winning repeat and Austria and Spain repeating on the downside later.

Much more important in the emerging market lead, both Hungary and Egypt went from the worst to the best in a few years time.

Using the Hungary/Egyptian model I would be looking for opportunity in both Canada and Singapore.

Question of the week: How do you search for future winners?     
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Copyright © 2008 - 2016
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Sunday, April 17, 2016

Beware of ‘Risk On’ Enthusiasm


Confidentially I will let you in on a big secret as long as you don’t tell anyone. The secret is that I can not predict the future and have serious doubts that others can sequentially. I view my responsibility as an investment manager is to review the possibilities of future events and attempt to refine them into logical probabilities and to determine whether these opportunities are priced rationally. I try to follow the precepts of strategic military intelligence, if that is not an oxymoronic belief. A strategic as well as a tactical commander should be supplied with an array of potential future events. The commander then makes the judgment as to which are probable and makes his/her plans accordingly.

Enthusiasm Risk

As regular readers of these blog posts may recall, I have taken the position that most stock markets top out with a demonstration of excessive enthusiasm. As we have not seen an example of this for some time, I have not been worried about a strategic decline. Historically these happen once in a generation and cause the general stock market levels to fall by 50% from their peak. For my long-term oriented accounts I have witnessed several tactical declines every decade in the order of 25%.

Too many of us think about only stock markets. This often is a mistake. Historically, elements of the bond market have performed the ‘canary in the mine’ function of warning about oncoming stock declines. Possibly a chirp could be heard this week. Having observed estimated weekly net flows by mutual funds and ETFs, I can see substantial inflows into both High Grade Corporate and High Yield (Junk) bond funds. In light of both the popular view of an eventual rise in interest rates when we exhaust the lower for longer phase plus current corporate operating data, bond investors could be subscribing to more risk which will be discussed more fully shortly.

This week on the equity side of the ledger there were also signs of growing enthusiasm. Forty out of forty-four global markets tracked weekly by The Economist showed gains. Further, the transacted volume of JP Morgan Chase* shot up from 17.7 million shares on average in the first two days of the week to 27 million shares on average in the last three days of the week.  One important element of caution for novice investors in bank shares is there is a second way to read the apparent discount between a bank’s stock price and its tangible book value. The market may be suggesting that the historic tangible book value is overstated. A proper analysis of a bank’s assets and liabilities, including contingent liabilities, could mean that current prices of many banks are appropriately priced and are not the bargain that the discount implies.
* Shares owned personally.

There may be another class of enthusiasm that should be identified. For about a year the US auto industry has been reporting close to historic sales levels of 20 million units. Even at last month’s rate of about 17 million, some of these gains are due to the fact that the average car on the road is 11 years old and the average light truck is 13 years old. However, some industry and financial professionals point out that the decline in gas prices has helped to fund purchases and many do not expect lower prices. At the same time the length of both leases and sales contracts have lengthened beyond past levels. Part of the growth for these has been characterized as sub-prime loans. The smarter banks have been cutting back on these loans. If one switches to sales dollars as distinct from unit sales the increases in SUV and light trucks has been meaningful and possibly replacements for lower priced and lower profit margin sedans.  (One of our two cars is an SUV purchased more than five years ago.) The car buying public has shown a bullish belief in our future.

Capacity Utilization and Productivity Warnings

At the same time that the level of industrial production is published each month another statistic is released and may have more impact on future profitability than production numbers. Capacity utilization measures how much of a plant’s capacity is utilized in that month’s production. The latest reading is 74.8%. This is 5% below the monthly average since 1972. This is significant for many plants an 80% utilization generates optimum operating margins. (Higher utilization rates will produce larger aggregate profits, but the last bits of capacity often are outmoded and produce lower margins.)

Profits are the direct result of the level of production and the productivity of labor. The risk to bond holders and particularly high yield holders is that revenues are currently growing at best very slowly if at all and wages are starting to rise. Moody’s believes that the default rate on non-energy High Yield bonds will rise this year as some of these companies’ profits will be squeezed between flat sales and rising wages.

Why are wages rising for new employees?  In order to survive, companies have been replacing manual labor with machine labor and in many cases not using outmoded plant capacity, which is written off when the plants are closed rather than on a contemporaneous basis. Regardless of the accounting niceties, the new machines require more skilled labor. These as a class are in short supply and hence result in high hiring costs.

Part of the reason for the shortage of highly skilled labor is the failure of our educational system, starting with the home and going all the way to the formal educational system including our PhD programs at elite universities. We are producing students who not only don’t possess adequate knowledge, more importantly many job seekers don’t have the right attitudes. They are not prepared for the workplace culture of integrity and cooperation. We are not producing people who are skilled at reading others in a group or individual basis, so they lack sales ability. (In any group of two or more, sales ability is needed to get optimum results.)

What to do?

Since I have let you in my secret, here is what I recommend for your portfolio under the current circumstances:

First, I recommend for consideration the development of timespan buckets or portfolios similar to the TIMESPAN L Portfolios®.

Second, one should make small and somewhat frequent portfolio changes, perhaps in one timespan bucket at a time.

Third, have sufficient diversification so one has appropriate hedges, in case some of the expected future trends don’t work out as expected.

Fourth, we live in a global world, whether we like it or not. As we can not escape from many global trends, keep that in mind in your selections of managers and securities.

Fifth, continue your learning process as we are trapped in a dynamically changing world and we need to wisely adapt.      

Question of the Week: Are you watching bonds to help with your stocks?
Did you miss my blog last week?  Click here to read.

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Copyright © 2008 - 2016
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.